One of the best financial moves I've been able to make these last few years is building emergency savings. Knowing that I have cash in the bank that can help me tackle a car repair or medical bill without resorting to putting it on a credit card is a good feeling. But it's not enough to have the emergency fund -- you need to have a safe place to keep it. Here are a few excellent options -- and one to avoid.
1. A high-yield savings account
Savings accounts are perhaps the simplest type of bank account, and they're a great choice for your emergency fund, provided you pick one of the high-yield options offered by many online-only banks. If you park your emergency cash in a big-bank savings account, you might earn only 0.01% APY (and watch the value of your money be eroded, thanks to inflation). But with an online bank, you could earn around 5.00% APY. That means real money -- and that delicious feeling of logging into your account and seeing that sweet interest payment once a month (interest payment day is one of the best days of the month for me).
Be mindful of the fact that your emergency fund may not be easily accessible in a high-yield savings account, though. Most of them don't come with an ATM or debit card, and so it pays to link a checking account with the same bank so you can easily transfer cash back and forth.
2. A money market account
If you crave easy access to your money and a high APY, money market accounts might just be right for you. These accounts are like a hybrid of checking and savings -- you get the high APY of an online savings account (right now, around 5.00%) combined with check-writing privileges or a debit card, like a checking account.
Money market accounts do sometimes come with a minimum deposit requirement to open, which is an important differentiating factor between them and savings accounts (the best savings accounts usually have no minimum deposit or balance requirement). Also note that many of these accounts have a per-month transaction limit, so don't think that a money market account can replace a checking account.
3. A Roth IRA
All right, here's the wild card pick! If you are generally financially solvent, you might want to consider an investment account for your emergency fund. Specifically, a Roth IRA -- which differs from a traditional IRA in that your tax break comes when you withdraw funds, rather than upfront. Thanks to this rule, you won't be penalized for withdrawing money from a Roth IRA before age 59 1/2, provided it's the money you contributed, rather than your investment growth.
Let's say you've put $15,000 into a Roth IRA over the course of five years ($250 per month), and in that time you've earned an 8% annual return (in line with the S&P 500's average annual return over the last 50 years, which has been 10%). Now you have an account balance of almost $17,600, and you can withdraw up to $15,000 of it without penalty, and still leave cash in it to keep growing.
Personally, I wouldn't use a Roth IRA for my emergency cash because I wouldn't want to take the risk of the market going through a down period and leaving me with less money to withdraw than I put in. Unlike the bank accounts I discussed above, investment accounts don't come with FDIC insurance. But depending on your risk tolerance, a Roth IRA could be a fit for your needs.
CDs are a terrible place for your emergency fund
Certificates of deposit (CDs) are having a moment right now. Many experts are predicting Federal Reserve rate cuts for later this year to bring us down from the current high federal funds rate. If the rate falls, rates on deposit accounts like savings, money market, and CDs will follow suit (the two aren't directly linked, but tend to move in concert).
But CDs are special among these accounts in that when you put money into one, you get to lock in the rate you start with for the duration of the CD's term, be it three months or three years. CDs with terms around one year have stellar rates right now -- you can earn 5% APY or better on your money if you can kiss it goodbye for a year.
But herein lies the danger of using a CD for your emergency fund. If your car breaks down, your roof leaks, or you have to pay an emergency room bill during the CD's term, you'll have to get your money out early, which will likely result in a penalty fee. The size of the penalty for early withdrawal varies based on the length of the term. But it would be a real bummer to lose out on that interest income and have to pay part of it as a penalty. And depending on how far into the term you are, you could find yourself even losing part of your principal.
In short, your emergency fund doesn't belong in a CD. Instead, look to savings and money market accounts, or even a Roth IRA, to hold your precious stash of cash.
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